Speech by SEC Commissioner:
Enhancement and Modernization of the National Market System
Paul S. Atkins
U.S. Securities and Exchange Commission
The National Market System was enacted by Congress in 1975 during a time in which there was pervasive government regulation of the marketplace. The fundamental beliefs that many in government held during this time proved faulty and are very different from those we hold today. President Nixon implemented the now thoroughly discredited wage and price controls in a futile effort to ward off inflation. The fiscal policy choices made during this time period proved to be devastating to our economy. Since then, the SEC has debated on several occasions whether the preferred market structure should be some sort of centralized market, concluding each time that it would be too harmful to the forces of competition and innovation. United States economic policy makers learned from their mistakes and earlier Commissions averted traveling down the same road, but I suppose this Commission must learn the hard way by making its own mistakes.
The adoption today carries out a plan devised under discarded hyper-regulatory notions and revives the spirit of the 70's by continuing to experiment with market centralization. The majority of the Commission apparently will decide today to sacrifice market efficiency in favor of managing competition and setting prices, all in the name of retail investors.
Proponents cite three objectives for this rule: decreasing trade-throughs, improving investor confidence, and increasing market depth and liquidity. Not one of these goals will be achieved. By the rule's very design, trade-throughs will still occur after implementation. The Commission has not concluded through any study that investor confidence has been affected by the minimal number of trade-throughs in the current market, yet we conclude that investor confidence will improve even though trade-throughs will theoretically decrease, not stop. The release claims that this rule will increase market depth, but that is unlikely to be achieved, because of persistent factors such as free-riding and the reluctance of buyers and sellers to suffer the market impact of showing their full interest. Why then are we adopting Regulation NMS?
The wisdom of adopting Regulation NMS is particularly questionable because of three unfortunate consequences of the rule: government-control of competition, government-control of market participant behavior to boost display depth, and stifled innovation. In addition to these concrete results, by extending the trade-through rule, the SEC risks introducing numerous unintended consequences to and responses by the markets. We can never predict how the market will adapt to new regulations but I can posit some potential consequences that could happen following NMS.
Regulation NMS, for example, could result in the introduction of new business models such as slow-quote markets and inferior markets. By failing to clearly delineate best execution and its obligations from the application of the trade-through rule, the slow-quote business model could provide intermediaries with market gaming opportunities and informational advantages or free options. By requiring orders to be routed to protected quotations, the trade-through rule and best execution features of Regulation NMS may preserve inferior markets . These markets would offer inferior quoted prices and second-rate technology, clearing and settlement, and other potentially mark-up or expensive services as a result of their protected quote.
Regulation NMS may provide a government stamp of approval for inferior executions. Today, many institutions try to beat the volume weighted average price, or VWAP. Post-NMS, the burdens associated with the trade-through rule may modify normal trading behavior and institutions may settle for the VWAP instead of a better price. In addition, the trade-through rule may increase volatility in small cap securities and make it harder for institutions to trade small-cap stocks in large amounts due to the market impact from compliance with the rule. This market impact may decrease the attractiveness of small-cap stocks to institutional investors and ultimately increase cost of capital for these companies. Market participants looking to avoid administrative burdens imposed by the trade-through rule may also execute the transactions after normal trading hours. This result may decrease transparency because these are orders that would otherwise be displayed during normal hours. In addition to all of these negative results, we may experience a slowing of market data feeds, operations and a decrease in competition. Overall, Regulation NMS may allow the NYSE to take one step forward, but, in doing so, it may drag the rest of the market backward.
Proponents of the Regulation NMS claim that the regulation is "pro-competitive". This term would be an accurate characterization if the competition that we strive for is to establish a set number of market players and artificially extend the life of existing, inefficient markets. Contrary to proponents' assertions, this rule hinders competition and new market entrants, which is inconsistent with the stated goals of the Exchange Act. In fact, this is a complete departure from, and in some respects a reversal of, the pro-competitive stance taken by the SEC in the SuperMontage approval order and Regulation ATS.
Regulation NMS, which purports to "preserv[e] competition among markets," instead raises the barriers to entry for new market entrants by limiting competition to those trading markets lucky enough to hold an SRO license and by establishing very high access standards. Regulation NMS limits competition by providing the protected quotation status to SROs only. New competitors need to obtain from the Commission staff either an SRO license or approval to become a new ADF participant.
Currently, nine markets hold an SRO license that entitle them to protected quotations and allow them to compete for trading services. In the post-NMS world, the Commission staff's SRO licensing power will allow them to give the illusion of increasing competition by approving more SROs and granting them the protected quotation subsidy. Will establishing a government selected and subsidized group of competitors result in "real" competition?
Since the enactment of the 1934 Act, the Commission has attempted to foster competition through unlisted trading privileges and again through the National Market System in 1975. Real competition developed in the Nasdaq market without trade-through or access provisions. In contrast, participants in the Commission-facilitated ITS system failed to innovate or aggressively compete. Against this historical backdrop, why does the majority believe it is wise to move ahead with a government-imposed market model? We tried it once, and it did not work.
The Fallacy of the Trade-Through Rule and Market Depth
Chairman Donaldson, at our last open meeting, argued for government interference with private choices of traders "[b]ecause the cumulative impact of their private choices - beneficial though they may be to the individuals themselves - can discourage the most precious resource of our national market system, which is liquidity." This viewpoint reflects a fundamental misunderstanding of how our markets work and why they are so efficient. Markets prosper based on millions of self-interested transactions engaged in by millions of people making billions of choices, not on the investors' desire to help the national market system as a whole with each trade. Should individual investors be concerned about the "public good" when they place orders for securities in our markets? Should not those investors be more concerned about getting their orders filled at the price and the manner they want? Isn't self-interest even more important if the decision-maker is a fiduciary for its own beneficiaries or shareholders? This is the essence of the Invisible Hand. The importance of investor choice is highlighted in comment letters from firms representing individual investors, including Schwab, Ameritrade and E-Trade, as well as from institutional investors such as Fidelity, TIAA-CREF and CalPERS.
The majority nevertheless persists in arguing that the trade-through rule is needed to decrease trade-throughs, improve investor confidence, and improve market depth and liquidity for the protection of these same investors. These objectives are unattainable because they are based on two assumptions that the release acknowledges will not and never be achieved: First, that the trade- through rule will stop trade-throughs; and second, that investors will post limit orders to increase depth.
The focus on trade-throughs is odd since the adopting release fails to establish that investors were significantly harmed by trade-throughs in the past. The trade-through study conducted by our Office of Economic Analysis, admittedly limited to a small sample size of four trading days, indicated that 2.5% of trades or $321 million a year in trade-throughs occurred. This relatively small number - one in 40 trades - suggests that brokers fulfilled their duty of best execution. Commenters claim that even this low number is overstated.
The majority admits that trade-throughs will occur under the new rule due to timing discrepancies, compliance with trade-through rule exceptions and system differences. Post-NMS, aggressive limit orders will still offer the market a "free-option" and trade-throughs may still disadvantage customer orders. Will the rule provide any meaningful difference from today when the SEC and NASD diligently monitor the fulfillment of broker's best execution obligations? The answer seems to be no if we look at the release, which fails to estimate any reduction in the frequency of free-options and disadvantaged trades resulting from the rule's adoption. Are we imposing millions of dollars in costs and new and unpredicted inefficiencies on the market for a $100 million cost savings, a $200 million cost savings or a $10 million cost savings? The majority hedges itself against the possibility of insignificant savings by stating that harm "is not a zero-sum redistribution and, consequently, the $321 million estimate of benefits is conservative as a measure of social welfare. It does not attempt to measure any gains from trading associated with investors' private values, beyond those expressed in their limit order prices." Social welfare, whatever that means, has replaced order competition driven by individual choice.
The delicate balance of supply and demand between short-term and long-term investors affects order competition significantly. Short-term investors' orders aggressively compete and narrow spreads. Long-term investors benefit by receiving better prices due to these tighter spreads. Short-term investors serve as the market's lubricant by providing additional liquidity. Thus, I am troubled by the majority's determination to mold the market supposedly for the benefit of long-term investors, which will restrict short-term trading strategies, and thereby decrease liquidity and decrease competition.
The release attempts to control market participant behavior by supplanting individual purchase and sale decisions. The basic acknowledged risks and costs associated with utilizing market orders, marketable limit orders or non-marketable limit orders are noticeably absent. The release attempts instead to reduce risk, or provide the perception of reducing risk, associated with placing orders in the markets.
The release makes a utopian claim that improved price protection will reduce the risk of posting limit orders or will create the perception of such benefits so that investors will be enticed to post limit orders. The release claims that the additional supply of non-marketable limit orders will improve market quality by increasing the fill rates for marketable limit orders on Nasdaq and will improve the execution price for market orders. These claims are based on the assumption that investors will believe that the rule removes from the market the risk is that an order will be traded through, the risk that an order will not be executed because the market moved away, and the risk that the market will free-ride off of the limit order. The attempt to eliminate risks is futile and unnecessary. Investors make conscious decisions to take these risks. Displayed orders provide information and impose market impact costs. Information about supply or demand affects the price of the product being bought or sold. Risk and the market reactions to it are not something to fear and certainly are not something the government cannot control.
The release also makes an unorthodox connection between the estimated $321 million in trade-throughs and the lack of market depth. The release states that the Trade-Through Rule will address this problem by increasing market depth. Again, the likelihood that market depth will be generated by the rule is questionable. Will institutions, as the source of this newfound liquidity, increase displayed liquidity when free-riding and market impact still exists?
Consequently, the majority's claim that the trade-through rule's creation of additional depth will lower long-term investors' transaction costs is unfounded. The release assumes that the "greater use of limit orders will increase market depth and liquidity, thereby improving the quality of execution for the large orders or institutional orders." How can execution quality improve and lower transaction costs if the trade-through rule does not generate additional depth? What if spreads increase because short-term liquidity is driven from the market? Would increased spreads and higher capital commitment costs negatively affect institutional and retail investors?
The release fails to address these questions and even contradicts the assumption that the trade-through rule increases market depth. The release acknowledges that increased market depth may not occur due to other existing factors, including free-riding and market impact. The majority consoles itself by stating that even if displayed depth fails to significantly increase, it will achieve the much more modest objective of - "increas[ing] the perceived benefits of order display, against which the negatives are balanced." Are we seriously pinning our hopes and altering our financial markets based on perceived benefits? Isn't it arrogant for the Commission to assume that it can manipulate the investor's state of mind and induce him to behave in a way that may not make any economic sense?
Regulation NMS's convoluted rule structure takes on the futile task of maximizing liquidity and depth and minimizing short term price volatility. The adopting release states that "[o]ne of the primary objectives of Regulation NMS is to help reduce [the $30 billion per year] market impact costs by improving market depth and liquidity." I question not only the estimated $30 billion figure, but also why we use the figure if modest objectives do not include maximum liquidity and depth. Would the modest objective improve market impact costs by $100,000 or $20 billion? The failure to cite an example of a market that has implemented the trade-through rule and increased quoted depth makes me believe that this is a theoretical experiment with an unpredictable outcome. Private market innovation and competition are much better suited than government regulation to develop an environment in which market participants will increase visible depth and transparency.
In the post-NMS world, the restrictions on competitive forces and the increase in bureaucratic red tape will inhibit future innovation. The lesson from the listed markets over the last thirty years suggests technology and other services will stagnate. Even if market centers do continue to innovate, the ability of market centers to remain ahead of the curve will be hampered by SEC micro-management. Even investor choices through trading strategies will be dictated by Commission exemptions to the trade-through rule. The slow pace of regulatory approval should concern those worried about the ability of our Nation's markets to innovate nimbly and compete with their foreign counterparts or derivatives markets. Two ready examples of the pace of government-overseen change include the Commission's five year deliberation of market structure and the staff's four year (and counting) approval process for considering Nasdaq's application for exchange status.
Regulation NMS will empower the Commission staff to tinker with every nook and cranny in the market, including trading strategies, access standards, access fees, market data distribution, market data fees, minimum trading increments and finally price fixing and rate setting. Regulation NMS will dramatically increase the pace of interpretive guidance and rulemaking approvals generated by SEC staff pursuant to delegated authority. With the discretion afforded by the rule, SEC staff will be empowered to dictate the operation of every market nut and bolt. Broad standards such as "unfairly discriminatory," "substantially equivalent," and the general grant of exemptive authority in this release will allow the Commission staff to determine how market forces and market participants' behavior should be controlled and modified. Can we expect staff implementation guidance to resemble centralized planning to ensure fair and equal competition between these markets? Why would the Commission want to become the market's mechanic and govern every minute detail of trading markets? -- After all, this Gremlin automobile is going to need a lot of work!
The current automated state of the Nasdaq market developed only over the last eight years. This rule adoption basically tells the world that this infant has grown enough and should stay a child for the rest of its life. The release acknowledges that the majority is memorializing present or past technology and market participant behavior when it notes that "the Commission's goal throughout the review of market structure issues has been to formulate rules for the national market system that adequately reflect current technologies and trading practices…" Does the majority really believe that VWAPs, intermarket sweep orders, price priority and a field of nine competitors is the best the market could ever hope to develop and should be the concrete manner of trading for the next 30 years?
Regulation NMS can be summed up best with an example about an online airline ticket purchase. Imagine if the government required the on-line web-based travel reservation system Orbitz to provide you with the lowest fare offered by nine government approved carriers. Would consumers be satisfied if they were forced to travel on Airline A instead of Airline B? Would consumers be satisfied by purchasing their ticket based upon price alone or would they view factors such as timeliness, routes, airport choice important when purchasing a ticket? If, so the government could attempt to make all services equal and standardize or commoditize services by requiring approved airlines to meet specified timeliness standards, comparable routes, compliance with specific lost baggage standards and other core benchmarks. The government would also require each airline to route customers to competing airlines offering better prices posted in a central system for seat and price availability within particular parameters. Thus, each airline could obtain guaranteed business by posting the lowest price. Shouldn't consumers be allowed to choose between two seemingly similar services and pay more to choose their own airline? Could the government rationalize such a mandate because airlines could still compete on the ticket price and empty planes would increase ticket flights for the public? Would such a system provide adequate incentives for the airlines to go beyond the government standards for timeliness standards, investments in new planes or customer services?
As you can see from this example, just because there are nine different airlines does not mean that there will be "real" competition between them. Real competition would mean that the airlines would strive to woo consumers based upon arrival/departure statistics, the condition of their airplanes and responsiveness to customer needs. Inefficient airlines would or should go out of business if the market does not support their continued existence. It's time for us to shed the 70s mentality and recognize that real competition is just as beneficial for the investing public as it is for the flying public.
Finally, when Chairman Donaldson testified a couple of weeks ago before the House Subcommittee on Capital Markets, he was asked specifically by Chairman Baker and other members of Congress from both parties to try to seek a consensus on an important rule like this, and to refrain from moving to adoption before the Subcommittee had a chance to examine the matter. Unfortunately, the day following Chairman Donaldson's testimony, we received this 500-page final release.
Much of the dispute regarding Regulation NMS stems from differences of opinion over congressional intent from 30 years ago when Congress adopted section 11A of the Securities Exchange Act. So, I would encourage our oversight committees in the Senate and House of Representatives to take up this cause explicitly and set us straight. It is time for Congress to give us clear, modern direction, so that we can stop looking longingly backwards and enter the 21st Century.
Thank you, Mr. Chairman.